The 3rd and last part of a series on Managing Payment Risks in International Trade especially During Economic Turmoil

Risk Management and Mitigation

All is not lost. Even during bad economic times, business can still flourish and payment could still be relatively safely received, if proper mitigation of risks are evaluated and undertaken by exporters.

First and foremost, the exporters will have to evaluate the existing manner in which the payments currently received from buyers are safe or not, in the event of the deteriorating economic conditions. If found unsatisfactory, then the exporters may want to move to a safer method of payment, such as moving to Documentary Credit from Collection or Open Account method.

If changing the method of payment is not possible due to existing contractual obligation or buyer’s refusal to re-negotiate the terms of payments, then it is advisable that exporters undertake some risk mitigation efforts, several of which are discussed below:

Protection of payment from Export Credit agencies – there are several financial institutions in Malaysia that provide payment guarantee to exporters, for a fee and subject to some terms and conditions, in the event of non-payment from buyers or their bankers. The cover provided is normally up to 95% of the export value, but in certain special conditions, arrangement can be made for a full 100% cover. This alleviates the risk of non-payment, but can only be enforced if the exports can prove that they have fully completed their part of the transaction, such as successful delivery of the goods and compliance to the terms of the contractual agreement.

Confirmation of Documentary Credit – if the transaction is conducted under Documentary Credit issued by foreign bank, the exporters can improve their risk position by getting the Documentary Credit confirmed. What the word confirmation means is that the obligation to make payment for the goods shipped under a Documentary Credit is provided by another bank, on top of the payment obligation provided by the bank who issues the Documentary Credit. This other bank is normally a bank of choice by exporters, usually banks in Malaysia but can also be international banks based in another country. Confirmation adds another layer of protection to the exporters, in the event the issuing bank is unable to pay due to financial distress or collapse, the other bank that provides the confirmation would step in and make good of their obligation to pay under that Documentary Credit. However, confirmation is only good and enforceable when the exporter fully complies to the terms and conditions of the documentary credit without any deficiency.

Silent Confirmation/Payment Guarantee – there are banks, especially those that deem themselves as big, global, international and reputable banks, that do not allow Documentary Credit issued by them to be confirmed by a third bank, an act which they may consider as blemishing their reputation and standing. In such situation, confirmation of Documentary Credit cannot be done, openly that is. However, the exporters can still avail themselves to a good risk mitigation tool, even under this condition, in what is called silent confirmation or payment guarantee. What it means is that the exporters can still get another bank to provide confirmation or guarantee of payment under the Documentary Credit, but it is done quietly, without the knowledge and awareness of the bank that issued the Documentary Credit. Silent confirmation/ payment guarantee is obviously more complicated and a little bit on the sophisticated side, but it is available for exporters who find themselves in this situation and wishes to improve their risk position further.

Without Recourse Financing – perhaps unknown to some exporters, especially the smaller ones, most trade financing provided by banks in Malaysia (and worldwide) is “with recourse” in nature, meaning that the banks provide export financing to exporters in good faith that the financing amount would be re-paid by export proceed eventually to be repatriated by overseas buyers and that, in the event that the payment for the export is not received, the banks reserve the right to recover their financing amount from the exporters themselves. This is obviously a very bad risk position for the exporters who, not only that they do not have the payments for the goods that they have exported, they have to source for other avenues and funding sources to re-pay the banks who have provided them the export financing. However, this is not a hopeless situation and exporters can avail themselves to a risk mitigation tool in the form of without recourse financing. There are several products of this nature available in the market such as forfeiting, bills purchased on without recourse basis, receivables financing and factoring. For a fee, what these without recourse financing tools provide is a truly peace of mind to the exporters, in the sense that they turn account receivables into immediate cash in their book.

Protection under “avalization” arrangement – in cases where the exporters get their payment under Documentary Collection and are unable to change it to a more favourable method of payment such as Documentary Credit, they can still reduce their non-payment risk by getting protection under “avalization” arrangement. The word Avalization originates from the French word aval, which is loosely translated by trade finance practitioners as protection or guarantee. The avalization arrangement is one where the buyers banker provides avalization or payment guarantee to to the exporters in the sense that the bank obliges itself to make payment to the exporters when the payment falls due. This is more or less similar to the obligation provided by bank to exporters under a Documentary Credit situation, except that in this case, there is no Documentary Credit involved. Thus, under the avalization arrangement, the exporters are getting similar payment obligation by the buyers’ bank, without having to get involved in a Documentary Credit transaction and its attendant complexities.

Hedging for Foreign Exchange fluctuation – although it is common for big exporters to hedge against forex fluctuation, this simple fact is sometimes lost among the smaller exporters, who are often left to face the vagaries of forex fluctuation, which can be detrimental to their financial position. Therefore it is absolutely advisable for the exporters to protect themselves against currency fluctuations.

Conclusion

It does not require the brain of a rocket scientist to be successful in international trade business, but it is not a walk in the park either. It requires a lot of common sense, conscientious efforts and sharp keenness, as opposed to local trade, so that the challenges and obstacles are properly evaluated and risks optimally mitigated so as to ensure success. To be aware of risks to payment and to take the necessary steps to improve risk mitigation will go a long way towards achieving success, longevity and continuity in the field of international trade business.

Payment Methods in International Trade - Part 2 of a series of 3-part article on managing payment risks in international trade during economic turmoil

Payment methods in international trade

There are various ways in which payments in international trade transactions for the goods exported are effected, each carries its own inherent risk, some major to the exporters while some are slightly lesser, while there is one particular method – not very popular though – where there is no discernible risk at all to exporter.

The first method of payment in international trade transaction is called Open Account trading, where the buyer will make payments to the seller after the goods have been received. Both parties would have had to agree earlier when the payment is to be effected, after the buyer has received the goods, whether immediately or, if the seller allows credit period to the buyer, some days or months later1. This method is very favourable to the buyer where he retains complete control of whether or when he wants to make payments for the goods that he has received from the seller. Because of the obvious risks of default by buyer, most sellers seldom want to engage in the business using this method except for those deemed trustworthy and of long-standing business relationship.

Another method that is in use to settle for payment in an international trade transaction is called Collection, where the documents of the goods being shipped are routed through banks with instruction to be exchanged with payment from the buyer, or in cases where credit period is granted by the seller to the buyer, against buyer’s signed acceptance and undertaking to pay for the goods when they fall due. Under Collection method, the seller is slightly better off, for several reasons. Firstly, there is now an involvement of third parties in the transaction, making it a little bit difficult not to pay up. Secondly, without the shipping documents, the buyer cannot go to the shipping company to clear goods. So, in order to get the goods he has to pay first or provide a legally binding written acceptance undertaking. Therefore, in terms of risk profile, Collection method is better to the seller than the Open Account trading.

However, the seller must not be carried away in terms of thinking that he is now on safe ground. Even under Collection, the fact remains that the buyer holds total discretion with regards to the payment for the goods and the seller relies entirely on the buyer’s willingness or ability to make payment. If, for whatever reason, the buyer does not pay up, the seller is totally unprotected, except for the contract that he may have signed with the buyer, which is legally difficult and costly to be enforced, especially if the seller is a small or medium size company and the buyer is in faraway countries.

Then there is another method of payment in international trade, one where would take away some of the payment risks faced by the seller, which is called Documentary Credit. Under this method, the responsibility to make payments to the seller for the goods and services that he has sold to buyer lies with the buyer’s banker. Under this method, by issuing the Documentary Credit, the bank assumes the liability to effect payment. This method is much preferred by the seller because it takes away the risk of non-payment, dispute, delinquency from the buyer. The seller no longer needs to worry whether the buyer can pay or not for the goods as the buyer’s banker will now make the payment.

However, there is a catch. The Documentary Credit issued by the buyer’s banker is neither a guarantee of payment nor an absolute way of getting paid. The Documentary Credit comes with terms and conditions that the seller needs to fulfill and comply with, before he can expect to be paid. If he cannot comply to the terms and conditions stipulated by the bank in the Documentary Credit, the seller will not get paid as well.

MANAGING PAYMENT RISKS IN INTERNATIONAL TRADE DURING ECONOMIC TURMOIL

The biggest reason people get involved in international trade business is so that at the end of it, they will get payment for their goods. This is an area that has given greatest head-ache (not to mention heart-ache) throughout the years as payments can sometimes be very difficult to receive. So I thought it is apt that I begin my blog by posting something about payment risk, which is at the heart of every businessman, local or otherwise.

This is the first part of a 3-part series about payment risks in international trade, especially in the time of economic turmoil:

MANAGING PAYMENT RISKS IN INTERNATIONAL TRADE DURING ECONOMIC TURMOIL

Economic uncertainty is upon us again, not long after the last credit squeeze crisis that impacted most of the Western world, rich Asian nations and other nearby regions. Lucky for Malaysia, we only suffered on the periphery of the crisis and largely emerged unscathed despite some slowdown in the export markets and some workers retrenched.

Many economists are predicting that the next global downturn is very much around the corner, including Nouriel Roubini, whose previous prediction about the credit squeeze crisis was largely ignored but proven correct, is again saying that the year 2012 will precipitate another economic meltdown if correct measures are not taken now to alleviate it. And this time, because of the near perfect conditions for the disaster to come, with European debt crisis affecting Greece, Italy, Portugal, Ireland, Spain and may be also France, plus the unmanageable national debt crisis faced by the US, which was down-graded a notch by S & P recently, and the spending cuts by the UK's Coalition government, the expected disaster looming around the horizon is feared my many to be more severe this time around.

This time Malaysia may not have the luxury of escaping the meltdown so easily, being a relatively small, open economy and dependant on external demand for our goods and services, when most of our major markets are going to go through a tough period of economic downturn, we may face the difficulties as well. Malaysian companies, especially exporters, have to be prepared for the worst.

Payment risks

Even during good time, payment risks are always a major headache to exporters. The risks range from the worst case scenario of non-payment of goods already delivered and taken up by overseas buyers to the less severe form of buyers asking for discounts, delay in making payments and creating disputes over the quality and specification of goods bought. Furthermore, if the buyer really means malice and want to defraud the exporter, they will make all sorts of excuses from making payment when the goods have been received.

The problems associated with payment risks will only increase when an economic downturn is taking place, where most buyers will be hard-pressed to make good of their obligations to pay for the goods and services that they have bought. Therefore, it is imperative that Malaysian exporters know what these risks are and plan ahead with strategies that would make them ready to face and mitigate those risks.

Apart from the risk of non-payment by the buyer, Malaysian exporters also face all sorts of other risks, which, if not properly mitigated and managed, would also result in losses of money for the goods sold.

Since most of Malaysian exports are conducted in foreign currency, the next big risk faced by our exporter is the foreign exchange risk, where the amount of money received in our currency is lesser than the amount the exporter expects, due to fluctuation of foreign exchange rate. If not properly managed and mitigated, the amount received may well be insufficient to cover the cost of goods sold, production costs and other overhead costs.

Then there is also transfer risk, where the money from the buyer's country may not be allowed to be transferred to Malaysia, due to whatever reasons, mostly political, especially if the exporter is selling to sanction countries. Although the transfer risk has nothing to do with the buyer's ability to pay, it also has got to be tightly managed to ensure that the payment for the goods and services sold is received.

In cases where the banks' services are used to facilitate or "guarantee" payments, the exporter, although slightly more secure, still faces the possibility of non-payment due to the banks themselves facing financial difficulties, as shown in recent financial meltdowns. So, even the use of financial institutions to assist exporters, non-payment risks remains high. It is important that the exporters are aware of these risks and the necessary precautionary measures accordingly.

Another growing risk that only recently manifests itself is the political risk, where countries may simply ungovernable or disturbed enough to prevent payments from those countries being effected to our exporters. This scenario is very much alive now in the most parts of the Middle-East, where the end-game is still unclear. This risk is very potent that unprepared exporters would have to meet heavy losses dealing with these countries, if it not carefully managed.

Prelude..

This blog is about international trade finance, where I would like to use is as a medium to share my thoughts, opinion and knowledge about the development in international trade, trade financing and trade servicing. This blog would be especially useful to those seeking to deepen their knowldedge and understanding about the intricate world of international trade, its financing instruments, terminologies etc, such as personnel in a trade finance/services department of a bank, a business owner, an importer, an exporter, as well as business students from our academic institutions studying about international trade, banking and financial services. I hope that this blog would, in its own small way, contribute towards greater and better development of international trade business in Malaysia, thus helping Malaysia to find its path in the complex world of international trade and emerge better prepared to face the vagaries and tribulation it faces as we move along this difficult and sometimes uncharted water of international trade business.